Answers to Do You Understand? Text Questions

CHAPTER 10 ANSWERS TO "DO YOU UNDERSTAND?" TEXT QUESTIONS

DO YOU UNDERSTAND?

1. What characteristics of an asset determine the type of secondary market in which it is most likely to trade?

Answer: New issues of securities are sold in the primary market. Any subsequent transaction in the security takes place in the secondary market. In the money markets, all securities are dealer-traded short-term debt securities; while the capital market is divided between debt (bonds and mortgage- related) and equity markets. Largest stocks tend to be listed on the NYSE. NASDAQ has more stocks listed than the NYSE, including some very large companies, but the average market cap of NASDAQ- listed companies is much smaller. Small stocks and micro-caps are traded in the OTC markets such as the Bulletin Board and Pink Sheets.

2. What are the four types of secondary markets?

Answer: The four types are (1) direct search, (2) brokered, (3) dealer, and (4) auction markets.

3. Explain how short selling works.

Answer: Investors may sell stocks they do not own, which is called short selling. The stock is borrowed by the broker from another investor. The short seller must keep the sales proceeds and a security deposit (margin) with the broker, and must pay dividends on the stock sold short. The short seller’s profit or loss is the difference between the original sales price and the price at which the stock is eventually repurchased. A stock is sold short by investors who believe the stock will decline in price.

4. How are the NYSE and NASDAQ different? How are they similar?

Answer: NASDAQ is a purely electronic market, while NYSE has a physical trading floor. NASDAQ is a dealer market, while NYSE has floor brokers and specialists, who act both as brokers and dealers in their assigned stocks. Historically, the prevalent method of transacting on the NYSE floor was through brokers seeking the best counteroffer on the exchange floor or simply trading with specialists. While NYSE traders still do it, nowadays they often execute orders electronically at the best bid or ask price (similar to NASDAQ). This signifies the NYSE’s transition into a hybrid market.

DO YOU UNDERSTAND?

1. Describe the general approach to valuing a share of stock.

Answer: First, estimate the size and the timing of expected future cash flows. Second, decide upon the appropriate discount rate to use in the present value calculation. Finally, apply the discount rate to the cash flows in each period to obtain present values of expected cash flows and sum the present values to obtain the value of the security.

2. What cash flows are relevant to the value of stock?

Answer: Dividends and capital gains are the sources of income from holding a stock.

1 3. Describe what happens to the total risk of a portfolio as the number of securities is increased.

Answer: As the number of securities increases, the diversification effect reduces the standard deviation of portfolio return, a measure of the portfolio’s total risk. Total risk can be reduced, however, only to the level of systematic risk, which cannot be diversified away because it is caused by general market movements that tend to affect all stocks similarly.

4. Suppose a firm’s stock has a beta of 1.2. What will probably happen to the value of the stock if the market decreases by 20 percent?

Solution: The value of the stock will probably decline by (1.2)20% = 24%. A positive beta means that the stock is positively correlated with the market. Because the beta is greater than 1.0, the stock will tend to have wider swings than the market, but in the same direction.